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Stocks and the Fiscal Cliff

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In late 2012, the US federal government had a difficult decision to make. How would it react to the deadline Congress placed on itself to handle the 2013 budget? These were tough questions, given the size of the federal debt, the lingering effects of the 2008 recession, and the perpetual questions about who should pay what tax rate and why.

Back in those days, everyone talked about something called "the fiscal cliff".

What is the Fiscal Cliff?

As part of earlier negotiations to improve the budget process, reduce the federal deficit, and attempt to pay down the federal debt, a committee of members of Congress agreed to a failsafe: if they could not agree on a plan, an automatic series of cuts to spending and expirations of tax rates would occur. See the Budget Control Act of 2011 for gory and boring details.

As you might expect, they did not agree.

The fiscal cliff was a manufactured crisis that no one wanted to happen: those spending cuts and effective tax increases. There's still time to reach a deal, but as 2013 approached, uncertainty increases. Almost everyone would like to find a compromise to avert the automatic cuts and increases.

If you want to get precisely technical about things, the US did go over the fiscal cliff on January 1, 2013. The sky didn't fall and Congress went on to pass the American Taxpayer Relief Act of 2012 by noon on January 1, 2013.

What did this mean for you? What might happen if this negotiation happened again? Consider a couple of hypotheticals, as if it were December 2012.

What Happens if Nothing Happens?

If there's no deal, federal taxes will go up—not just income taxes, but also payroll taxes. In effect, everyone who works and has money deducted from a paycheck will see less money in every paycheck. As well, federal money spent on various government programs will diminish.

Because the current economic malaise is a demand-side problem (there aren't enough people willing to spend money in places where it matters), and because the most effective way to stimulate the economy is for the federal government to distribute money to the people most likely to spend it (the poor and especially the working poor), it's likely that a second recession will occur.

Almost no one wants that.

Yet if this does happen, the effect on the stock market will likely reflect the weakening economy: prices will tend to go down. If you're waiting for stocks to go on sale, this is an opportunity to buy, but who knows how long the weakness in the economy will linger in the stock market?

What if Taxes Go Up?

If Congress finds a compromise, it's likely that some taxes will increase (in that temporary tax rates are likely to expire). If Congress manages to leave the payroll tax cuts in place for the near future, the economy will have a chance to improve (or at least not get any worse), as more money will be available for the people who most need to spend it to spend.

It's plausible that the tax rate on things like dividend income and capital gains will increase. This will affect you in two ways. First, you'll have to get better returns from your investments to make the same amount of money—if you pay more in taxes, you'll realize smaller gains when you sell. (This is a good reason to practice value investing, which minimizes the number of times you buy or sell and, consequently, spends less of your money in taxes because you take larger profits less often.)

Second, companies which pay dividends will probably pay fewer dividends. If shareholders have to pay more in taxes, dividends will be less attractive. (Companies that pay really big dividends will probably continue to do so, but expect other companies to use that money to buy back more shares instead, which should push up stock prices.)

If your taxes go up (whether through rate cuts expiring or removal of deductions), it's more important than ever to practice wise investing through buy and hold investing and choosing great companies to invest in.

What if Taxes Stand Still?

This is probably the best case scenario. If tax rates stay the same, dividends will remain historically cheap and stocks which pay dividends will be attractive. You won't have to work any harder to beat the market's returns after taxes if your tax rates stay the same.

The Stock Market and the Fiscal Cliff

What did the stock market do?

Throughout December, the stock market wavered a bit. For every dip in prices, commentators were quick to blame "The fiscal cliff is eroding investor confidence." (No one was much surprised the media covers stocks so lazily.) Yet stocks rose in general from November through December.

With the announcement of the "resolution" of the fiscal cliff issue through the American Taxpayer Relief act enacted on January 1, 2013, the market jumped. In 2013, the S&P 500 index gained almost 30%. It increased just over 11% for 2014. Good investors found some bargains and made some money.

No one can predict what the stock market will do in any given day, but because stock prices have a connection to expected earnings, any suggestion that the economy will slow down again tends to drive prices lower, at least for the market as a whole.

This can be depressing, but it can be very profitable to find good stocks at bargain prices. If you have great investments, stay the course. If you're looking for new investments, keep in mind that daily, weekly, or monthly fluctuations in prices are merely bumps in the road to success.

No matter what happens with a future fiscal cliff, budget negotiations, tax rates, or any other federal economic policy, investment success still depends on your ability and willingness to find great stocks, buy them at good prices, and wait patiently for the market to reward your diligence and hard work.